20.08.2018

AllianceBernstein Schweiz AG

Midyear Outlook: What a Trade War Could Mean for the Bond Markets, and More

We answer some of today’s most pressing investor questions—from the effect of trade wars with China to our expectations for rising rates and a correction in high yield.

Keep your eye on the (most important) ball—liquidity

Markets can react somewhat capriciously to short-term pressures and surprising or unusual events. Sometimes news seems to matter too much, sometimes not enough. Market volatility in general—particularly the tendency for markets to overreact and then correct—reflects overall levels of liquidity.

That’s why it’s important that investors stay focused on the overriding force at play in this environment: the transition from massive liquidity levels to less-than-ample liquidity. The former was the result of global central banks’ decade-long QE campaigns and low, low rates. Our global transition to the latter has only recently begun, now that the US Federal Reserve is hiking rates and reducing its balance sheet.

There is much more to come, with quantitative tightening to begin in Europe too.

The shutting of the liquidity spigot—how fast, how much, how tight—is likely to have a bigger influence on financial markets than it does on most developed markets’ economic growth rates. This shouldn’t be surprising, since financial markets have dramatically outperformed the global economy since QE began nearly 10 years ago. To expect a reversal of this pattern under a quantitative tightening regime is well within reason.

Of course, each region and country will be affected differently by global and domestic pressures. For instance, an escalation of trade tensions will have a dampening effect on the global economy, but with greater hits to those economies where trade is more important. And although the Fed’s influence is designed to most directly impact the US, its second-order impacts on non-US economies and markets are greatest on those that cannot as easily withstand the burden of this changed liquidity environment.

That’s what continues to hold our attention, even as we recognize and assess the many other influences on the market. With that as the backdrop, here are our answers to the questions we’re hearing most often today.

How will a trade war impact the bond markets?

Although President Trump has threatened additional tariffs on all Chinese imports, which would represent more than $500 billion, the direct impact of the tariffs announced thus far will probably be small. For example, we expect the effective US tariff rate on overall imports will rise from 1.4%—the average since 2000—to just over 2%. Other countries, with smaller GDPs and more trade-dependent economies, will experience relatively bigger direct impacts.

But first-order, direct impacts aren’t the only effects we’re paying attention to. There are second-order effects as well. Already, the US dollar has climbed sharply since trade tensions moved to center stage, and volatility has ramped up in the financial markets. Longer term, the net effect on the US dollar will be determined by relative changes in growth rates, underscored by companies’ varying ability to pass on the costs of tariffs to consumers. Remember: the weak US dollar helped global asset prices in 2017; conversely, a strengthening dollar today could be troubling for financial markets worldwide.

Additionally, it’s important to consider the potentialities if we take the trade wars to their logical conclusion. And these seem considerably more serious.

The US currently runs an enormous trade deficit, leaving China—and every other country against whom the US runs a deficit—with a large supply of dollars. Chinese economic participants are constantly affecting markets by either returning those dollars to the global system—exchanging dollars for renminbi—or by investing them in the financial markets, much of it the US capital markets. This circulation of goods, US dollars and investments (with China and with the US’s other trading partners) has existed in a happy equilibrium—until now.

Now, with a stated aim of reducing the US trade deficit, President Trump is choking trade, effectively shrinking the supply of US dollars available outside the US. Fewer available dollars means fewer dollars sold back into the global currency markets, causing the relative value of the dollar to climb. (And remember that a strong dollar is generally bad for financial asset prices.) Fewer available dollars also means a disruption to direct investment in the capital markets.

In other words, by decreasing the US’s trade deficit, Trump will be decreasing flows into financial assets, especially foreign purchases of US securities, from Treasuries to company stock to direct real estate investments. Should the president pursue a path that takes the US trade deficit down to zero, the US dollar would soar, and the financial markets would plunge.

Thankfully, we don’t think this apocalyptic vision is likely to be realized. Instead, it’s more likely that cool heads will recognize the potential for damage to global growth and the capital markets and negotiate a compromise. Still, tensions are likely to worsen before they improve, so we are monitoring the situation closely.

For now, we see a trade war as a reason to trim exposures to emerging-market (EM) currencies, particularly if China purposefully weakens its renminbi. Although we do not see a deliberate weakening of the Chinese currency as the base-case scenario, the effect of such a weakening would ripple through Asian EM currencies and through EM currencies generally.

Who will be the US winners and losers in a trade war with China?

With the above backdrop in mind, we see the clear US winners as being sectors that benefit from US tariffs but do not sell into China. These include metals and chemicals. The clear losers are sectors that do not benefit from US tariffs and that sell into China, particularly agriculture—apples, cherries, wheat, seafood, dairy products and more. Somewhere in the middle are sectors that potentially benefit from tariffs but also sell into China: industrials, capital goods, technology, transportation and autos, and retail.

Additionally, it’s important to weigh the secondary impact of tariffs and a trade war. They’re especially negative for sectors exposed to rising input costs (steel, resin, plastics) and with limited pricing power: consumer goods, food and beverage, and retail.

We’re also concerned about the potentially negative effect on US companies’ capital investment decisions as uncertainty around tariffs continues. An associated slowdown in productivity gains could overwhelm the otherwise constructive backdrop of last year’s US tax cuts and the ability of companies to repatriate overseas cash. This dynamic could have an impact even on businesses currently flush with profits, but it’s more likely to hurt those with less wiggle room.

Lastly, a prolonged trade war could throw Fed monetary policy into question. While the Fed’s inflation target of 2% was recently reached, that may not stick: one effect of a trade war would be pricier imports, which would add to inflation pressures. And rising inflation would keep the Fed tightening for longer.

What’s the significance of a flatter US Treasury yield curve?

An inverted yield curve—when long yields dip below short yields—has heralded every recession since the mid-1970s. So it’s understandable that a flattening yield curve causes investors to prick up their ears.

We do not anticipate a recession in the US anytime soon. Rather, we expect continued strong, stable growth over the next few quarters, with a modest slowdown developing as gradually higher rates and tighter monetary conditions take effect.

It’s important to understand the other forces that shape today’s yield curve. One such force is the sheer amount of liquidity that’s been pumped into the market by global central banks. But perhaps the most significant force right now is the volatility backdrop. Market jitters around trade wars, especially, have led to Treasury buying, even as the Fed is propping up the shortest Treasury yields via tightening. The result? A flattening curve.

The flatness of the curve is particularly interesting given the market’s current supply/demand technicals. We know that there are two large participants increasing supply. First is the Fed, as it shrinks its balance sheet. Second is the US Treasury Department, which needs to issue a larger amount of debt to finance the expected budget deficit following the tax cuts and the fiscal package agreed upon earlier in 2018. Additionally, foreign central bank holdings of US Treasuries have diminished, indicating that they too are sellers.

Yet, the price of Treasury bonds has not dropped much. We must therefore assume that there are equal or larger buyers on the other side. To us, that means the flattening of the curve shouldn’t be ignored.

How should I invest in today’s volatile bond markets?

Six months ago, we warned that 2018 would be a year of transition for financial markets. With the global economy humming along, we predicted that central banks, led by the Federal Reserve, would gradually tighten financial conditions by hiking rates and shrinking their balance sheets, causing volatility to rise and investing to get more challenging. We simply didn’t expect it to happen so quickly.

By midyear, the yield on the benchmark 10-year US Treasury note had risen from 2.40% at the start of the year to 2.90%, with a brief run to 3.11% in mid-May. And the US dollar has appreciated sharply, provoking a broad sell-off in EM bonds and currencies.

We don’t expect a prolonged sell-off in risk assets, however. That’s because this kind of turbulence is part of the ebb and flow we expected when the year began. The global economy remains healthy, making it easier for corporate borrowers and most EM governments to service their debt even as rates rise. And Fed tightening will be somewhat offset by a more gradual reduction in monetary accommodation elsewhere. Still, we don’t see this as a time to ramp up portfolio risk.

The European Central Bank, for example, announced it would end quantitative easing in December. Together with Fed tightening, this should cause continued pressure on credit spreads. And a stronger US dollar means EM central banks can no longer afford to loosen monetary policy to offset tightening financial conditions as we and other market participants expected they would.

Beyond that, there’s concern that a drawn-out trade war could dent business confidence and undermine the world economy and markets. Meanwhile, Western governments from Rome to DC are embracing ambitious fiscal spending plans despite high deficits and, in the US’s case, an economy that’s already at full employment. These developments are likely to lead to higher inflation over time and could curtail global growth.

We think it makes sense to rebalance overall portfolio risk. Our interaction with investors around the world indicates that, on average, their overall bond exposure needs a more dynamic balance between credit-sensitive assets and interest-rate-sensitive assets. Many investors have been very underweight duration as the ECB and Fed have been withdrawing accommodative policy, which has left portfolios very skewed towards credit risk. We believe that the best course is to continually assess the current balance of risk and reward in credit and rates, adjusting accordingly.

Using this dynamic approach, the portfolio manager alters the exposures to credit and rates as valuations and conditions change. This helps minimize risk by preventing investors from reducing duration too much, as well as from tilting too far into credit. It also takes advantage of the interplay between the two risks—the most important dynamic for investors to manage today.

Where next for European investors?

In the light of recent bouts of volatility, we think it makes sense to reintroduce some safe-haven assets into portfolios. US Treasury bonds in the middle part of the maturity spectrum seem to offer this stable quality, and they trade closer to fair value after this year’s repricing. By contrast, the ECB is yet to taper its asset purchase program, so we remain cautious on German government bonds.

Investors should also consider buying some inflation protection, since the market hasn’t fully priced in the likely inflationary impact from healthy global wage growth and protectionist trade policies. Higher-quality credit in the US now offers better value than at the beginning of the year—spreads have widened amid trade policy concerns and stronger supply. Given the flatness of the yield curve, investors should favor shorter-maturity corporate bonds.

Both US commercial mortgage-backed securities and emerging-market debt present some attractive opportunities. Both asset classes have come under selling pressure, and they’re pricing in a very negative outlook that we believe is unlikely to materialize. Consequently, active investors can find attractive yields in these markets, even after allowing for hedging costs from the dollar into the euro.

Closer to home, European investors can access an attractive level of income with subordinated bank bonds, which are supported by improving bank balance sheets and a positive outlook for the European economy.

Paying attention to what matters most

To be sure, trade wars and escalating trade tensions are important. However, it’s critical that investors keep their attention trained on the most important factors at play in today’s bond markets: the transition from quantitative easing to quantitative tightening, and more restrictive liquidity conditions. These are what have caused the weakest links in the capital markets to decline this year, and these are what will eventually cause risk assets to roll over.

Even the most skilled bond manager can’t time when that will happen. That’s why we believe that a sensible, balanced approach to fixed-income investing is best.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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